FRANKFURT (Reuters) - Big time politics from elections to trade wars will overshadow the European Central Bank’s policy meeting next week, keeping investors on the edge with markets seen prone to continued volatility after a recent equity rout.
Germany could finally get a government, nearly half a year after elections, but political wrangling in Italy, the euro zone’s third biggest economy, is only beginning as polls point to a potentially messy, inconclusive vote on Sunday.
Europe’s political turmoil comes at an especially sensitive time, with the U.S. administration appearing to be launching a full-scale trade war after President Donald Trump announced new restrictions and said “trade wars are good and easy to win”.
Italy’s vote is almost certain to produce a hung parliament, leading to weeks of negotiations. Investors fear this may produce a patchwork coalition that may be prone to instability and could struggle to reconcile diverging views on key political issues, including the country’s relationship with the European Union.
“We expect such a government, regardless of whether it is formed only by centre-right parties or is a mix of traditional centre-left and centre-right parties, to remain exposed to risks of a government crisis and/or snap elections during the next legislature,” Fabio Fois at Barclays said.
“We think the spectre of political instability could cast a long shadow, as a future coalition government may group together several political parties with very different views on critical subjects such as fiscal policy, structural reform implementation and the relationship with European partners and authorities,” Fois added.
In Germany, the trials of Chancellor Angela Merkel could finally come to an end when a prospective coalition partner votes on a tie-up that could finally put a government in place.
But a five-month ordeal to form a government is seen having weakened Merkel, even if the deal would produce a pro-European government that could finally push ahead with a key reform agenda for Europe.
“Irrespective the outcome of the vote, the next administration is likely to be less stable than the previous one,” Bank of America Merrill Lynch said “Discussions over Merkel’s succession are likely to intensify... Risks of new elections before fall 2021 remain..”
Europe’s political squabbles come as the bloc is enjoying its best economic run in a decade, with growth well above trend and employment at record highs, even if some recent indicators suggest that growth may have peaked.
Still, the political noise could potentially complicate the bloc’s response to U.S. trade restrictions, a worry for the continents policymakers since the EU may be the only bloc large enough to orchestrate an effective response.
Trump announced on Thursday he would impose hefty tariffs on imported steel and aluminium to protect U.S. producers, risking retaliation from major trade partners like China, Europe and neighbouring Canada.
“Retaliation would probably be concentrated on certain farm products, that would hurt US states with a strong Trump support base,” ABN Amro’s Arjen van Dijkhuizen said. “We consider a serious rise of protectionism the key risk to our outlook for global trade.”
The prospect of a trade war and attempts by some U.S. officials to talk down the dollar will also complicate life for the ECB when it meets on Thursday to discuss how to normalise policy after years of extraordinary stimulus.
The strong euro has already been highlighted by policymakers as a key source of concern and the bank is likely to keep policy firmly on hold, worried about market turbulence, the currency and a dip in both headline and underlying inflation, a Reuters poll of economists showed.
Policymakers are likely to discuss dropping their so-called easing bias, a stipulation that asset buys could be increased, if necessary, but a broader revision of its policy guidance is likely to happen later, possibly over the summer months, sources close to the discussion said.
ECB President Mario Draghi may also repeat his message from January that the bank might have to review its policies if the U.S. seeks to talk down the dollar to gain a competitive edge in trade.
Still, given rapid growth, the ECB is likely to remain on course to end its lavish, 2.55 trillion euro ($3.14 trillion) bond buys by the close of this year, confident that inflation will eventually rise, even if only slowly.
While Draghi is unlikely to play up the prospects of an exit, he is also not likely to dismiss them, which would be taken by investors as confirmation for their base case, including the end of bond buys in December after a short tapering period and a rate hike by mid-2019.
“Unless Sunday’s political events in Italy and Germany unexpectedly lead to strong market turmoil, next week’s ECB meeting should mark another cautious and very subtle next step towards the quantitative easing exit,” ING economist Carsten Brzeski said.
($1 = 0.8118 euros)
Editing by Toby Chopra